Department of Defense Implementation Strategies for Audited Financial Statements.

In May 1998, the President issued a memorandum to the Heads of Executive Departments and Agencies establishing goal obtaining an unqualified audit opinion--the best opinion an auditor can provide--on the government-wide financial statements. Due to the materiality of the Department of Defense's financial statements on the consolidated financial statements of the U.S. Government, it is imperative that the Department receive an unqualified opinion on its agency-wide financial statements if the President's goal is to be achieved.

For Fiscal Year (FY) 1999, the Office of the Inspector General, Department of Defense (OIG, DoD) issued a disclaimer of opinion on the Department's agency-wide financial statements and the General Accounting Office (GAO) rendered a disclaimer of opinion on the government-wide financial statements. In rendering these opinions, the auditors noted deficiencies in five major categories. These "show stopper" issues are: (1) property, plant and equipment; (2) inventory; (3) liabilities; (4) fund balance with Treasury; and (5) intragovernmental eliminations. The Department is in process of modifying and retooling many of its financial and nonfinancial systems to encompass new functionalities and adequately capture and report the financial information needed to obtain a more favorable audit opinion. However, due to the sheer number and complexity of the systems requiring overhaul, the Department expects these system changes will not be completed prior to FY 2003.

As an interim solution until compliant financial management and feeder systems are in place, the Department has developed Implementation Strategies to achieve a more favorable audit opinion on the DoD agency-wide financial statements.

Implementation Strategies

To address the major "show stoppers" identified by the audit community-and until the Department can implement the long-term solutions of modifying existing systems or introducing new systems to accommodate the federal-wide accounting standards-interim (short-term) strategies have been implemented to help improve the reliability of its financial information and to achieve an unqualified audit opinion. These strategies span both the financial and nonfinancial communities, and require a commitment of resources-both personnel and funds.

Property, Plant and Equipment (PP&E).

Recently approved accounting standards require PP&E to be reported at acquisition (i.e., historical) cost and depreciated. To validate the original costs, auditors want to see the original receipt or purchase document. However, the federal government's record retention policies are not consistent with current audit requirements.

For example, the National Archives and Records Administration requires that accounting records be maintained only for six years and three months. When the auditors attempt to audit assets that are older than six years and three months, they have difficulty finding documentation to support the reported values because the activities typically do not maintain documentation beyond the required retention period. This does not mean that the values reported by the Department are incorrect, rather it means that the auditors cannot verify the values reported.

To mitigate this audit deficiency, the Department has engaged two of the largest and most prestigious public accounting firms in the world to provide a value for the Department's property that would be acceptable to the Department's auditors. Recently, the public accounting firm assessing the value of the Department's real property indicated that the recorded values were materially accurate for the Department's real property. Results of the efforts on the values of personal property are not available at this time.

Additionally, because the Department's accounting systems were not designed to capture, retain, and depreciate the costs of PP&E assets, the Department is working with the audit community, and has asked public accounting firms to assist, in developing guidance, processes, and other changes needed to resolve these systems deficiencies. This is an enormous undertaking for the Department because of the tremendous number of PP&E assets that the DoD owns worldwide. [A more detailed discussion of the Department's efforts related to the management of Property, Plant and Equipment is contained in the article beginning on page 42.)

Inventory. Similar to PP&E, the new accounting standards require a valuation of inventory based on historical cost (the amount paid) or latest acquisition cost (a revaluation of all items in stock to equal the amount paid for the last item purchased). When the latest acquisition cost is used, the difference between historical cost and the latest acquisition cost must be reported as an unrealized gain or loss--in effect resulting in latest acquisition cost equating to historical cost.

Inventory values are not contained in DoD financial systems. Instead, such information is included in logistical (nonfinancial) inventory systems. These systems do an excellent job of ensuring that our troops have the parts they need at the place and in the condition required to perform their combat missions effectively and efficiently. However, the systems were not designed to provide accounting data to support financial statements--which became a requirement only beginning in FY 1998. Nor are the Department's logistics systems sufficiently integrated with the Department's financial systems to pass, in an automated environment, information that is required by the new federal accounting standards. Additionally, these logistical inventory systems often value inventory at selling price--not historical cost or latest acquisition cost. As a consequence, the dollar value of inventory reported on financial statements is a calculated, vice a system driven, amount. These calculated amounts are determined using a comp utational formula that adjusts logistical inventory values to an approximation of latest acquisition cost and historical cost.

The Department's logistics and financial communities are working together to improve the quality and reliability of the financial inventory amounts that are reported and are actively pursuing process improvements that will better comply with the new accounting standards. As inventory systems are renovated or replaced, new functionality that will better support audited financial statements will be added.

Liabilities. The Department faces several impediments to auditable financial statements because some of the Department's future liabilities have not yet been fully assessed. These potential future liabilities include environmental cleanup efforts, disposal costs of weapon systems and facilities, military postretirement health benefits and claims, as well as other future liabilities.

Current federal accounting standards require reporting the estimated costs of known and potential future environmental liabilities associated with the Defense Environmental Restoration Program (cleanup from past waste disposal practices at active and closed installations and formerly used defense sites); cleanup of closed, transferred, and transferring training ranges; preservation and management of active and inactive training ranges; and the future disposal of weapons systems (nuclear powered ships and submarines) and chemical munitions. Other potential future environmental liabilities that are less certain must be disclosed. Many of these costs will not be incurred until 20, 30, or even 40 or more years in the future, and have not yet been fully assessed.

The Department only recently established policy and procedures to estimate the expected environmental cleanup and other disposal costs for major weapon systems such as aircraft, missiles, ships, submarines, and ammunition. The Department of Defense Financial Management Regulation has been revised to incorporate specific guidance that clearly identifies the requirement for managers, at all levels, to recognize estimated environmental cleanup and other disposal liabilities. The DoD Components are continuing efforts to improve their estimated liability calculation for financial statement purposes.

Military post-retirement health benefits and claims liabilities are amounts that are estimated to be paid over a period that could be as long as the next one hundred years. In reporting an actuarial liability for military post-retirement health benefits and claims, historically the Department based its estimate on prior actual obligations. However, the new accounting standard requires that, to be acceptable estimates, these liabilities must be determined through the use of accrued costs instead of budget obligations.

The Department is enhancing its ability to report military post-retirement health benefits liabilities using factors that are more in accordance with the new accounting standards. The DoD, in partnership with the GAO and the OIG, DoD, has formed a working group to evaluate the use of various cost data as a means to measure future liabilities. This data will be the baseline used to calculate estimated liabilities for future financial statement reporting purposes.

Fund Balance with Treasury. The Department maintains its own checkbook. Thus, similar to private firms that keep their own checking accounts, the cash balance reported by the bank should be reconciled with the firm's check register. Similarly, cash balances on the books of the U.S. Treasury should be reconciled with cash balances on the Department's books. In the past, the Department's financial statements reported the amounts provided by the U.S. Treasury instead of the balances reflected in the Department's financial records. Frequently, the account balances at the U.S. Treasury do not agree with the account balances on the Department's financial records. These differences are caused primarily by timing differences that result from separate accounting and reporting systems that are not integrated or other agencies disbursing on behalf of the DoD.

As approved by the Office of Management and Budget (OMB), the Department will discontinue reporting the cash balances reported by the Treasury and, instead, report the fund balance shown in the Department's "Fund balance With Treasury" general ledger account at the appropriation level, as may be adjusted for appropriate changes. Any differences between the amount reported by the Department and the balance in Treasury's accounts will be explained in footnotes to the financial statements.

To improve this process in the long-term, the Department plans to better integrate disbursing and accounting systems and require periodic reconciliations of the installation-level and headquarters-level funds with the U.S. Treasury account balances.

Intragovernmental Eliminations. In preparing audited financial statements, current accounting standards require the Department to eliminate the value of transactions between different DoD Components. Similarly, for the government-wide statements transactions between federal agencies are required to be eliminated.

In reporting accounts payable, expenses, and disbursements from other federal agencies, there are no standard federal government-wide policies, procedures, or processes. As a result, the Department routinely does not receive accrual data prior to the receipt of goods or services. The Department's accounting systems were not designed to aggregate accounts payable and expense data by individual providers of goods and services.

The Department's short-term strategy to improve intra-governmental eliminations includes requiring the Military Departments and the Defense Agencies to identify major trading partners that make up the bulk of interagency transaction balances. As part of the Department's long-term effort to improve financial processes and systems, the Department will continue to work to better identify both the buying and selling parties of each intragovernmental transaction (at the transactions level) and use this information to generate eliminating entries and/or conduct required reconciliations.

Conclusion

Achieving an unqualified audit opinion is one of the Administration's important goals, and presents a daunting challenge to the Department. To attain this goal, the Department is aggressively pursuing efforts to improve the manner in which financial information is captured and reported. The Department also is overhauling its financial and nonfinancial systems to ensure they can implement new federal accounting standards. However, it will be several years before these new systems will be fully operational.

In the interim, the Department is pursuing alternatives to improve its financial management and achieve more favorable audit opinions. The Department has undertaken Herculean efforts to implement alternative strategies to comply with the Chief Financial Officers Act and other legislative changes, and the government-wide accounting and financial reporting requirements. In addition to employing in-house resources in terms of staff and facilities, the Department has spent, and plans to spend, millions of dollars for contractor assistance to aggressively improve systemic deficiencies throughout the DoD. These actions require enormous efforts from all functional communities within the Department--not just the financial community--and are being taken in partnership with the OMB, the GAO, and the OIG, DoD. These Implementation Strategies address each of the deficiencies noted by the audit community. When fully implemented, these Implementation Strategies are expected to allow the Department to attain a more favorabl e audit opinion on the Department's financial statements, and provide decisionmakers with better financial information.

Sandy Lyons has over 23 years experience in DoD financial management, including accounting, budgeting, manpower analysis, quality and productivity planning, and business management theory and application. She has held a variety of positions within the Office of the Secretary of Defense and currently serves as a senior financial management analyst within the Office of the Under Secretary of Defense (Comptroller), Directorate for Accounting Policy.